§1. Interest and Purchasing Power of Money

We have seen that, theoretically, the rate of interest should be subject to both a nominal and a real variation, the nominal variation being that connected with changes in the standard of value, and the real variation being that connected with the other and deeper economic causes.

As to the nominal variation in the rate of interest, we found that, theoretically, an appreciation of 1 per cent of the standard of value in which the rate of interest is expressed, compared with some other standard, will reduce the rate of interest in the former standard, compared with the latter, by about 1 per cent, and that, contrariwise, a depreciation of 1 per cent will raise the rate by that amount. Such a change in the rate of interest would merely be a change in the number expressing it, and not fundamentally a real change. Yet, in actual practice, for the very lack of this perfect theoretical adjustment, the appreciation or depreciation of the monetary standard does produce a real effect on the rate of interest, and that a most vicious one. This effect, in times of great changes in the purchasing power of money, is by far the greatest of all effects on the real rate of interest. This effect is due to the fact that the money rate of interest, while it does change somewhat according to the theory as described in Chapters II and XIX, does not usually change enough to fully compensate for the appreciation or depreciation. Edition: current; Page: [494] The inadequacy in the adjustment of the rate of interest results in an unforeseen loss to the debtor, and an unforeseen gain to the creditor, or vice versa as the case may be. When the price level falls, the interest rate nominally falls slightly, but really rises greatly and when the price level rises, the rate of interest nominally rises slightly, but really falls greatly. It is consequently of the utmost importance, in interpreting the rate of interest statistically, to ascertain in each case in which direction the monetary standard is moving and to remember that the direction in which the interest rate apparently moves is generally precisely the opposite of that in which it really moves.

It should also be noted that in so far as there exists any adjustment of the money rate of interest to the changes in the purchasing power of money, it is for the most part (1) lagged and (2) indirect. The lag, distributed, has been shown to extend over several years. The indirectness of the effect of changed purchasing power of money comes largely through the intermediate steps which affect business profits and volume of trade, which in turn affect the demand for loans and the rate of interest. There is very little direct and conscious adjustment through foresight. Where such foresight is conspicuous, as in the final period of German inflation, there is less lag in the effects.